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Supreme Court Rules Security for Future or Contingent Debts Ineffective upon Debtor's Bankruptcy

Czech Supreme Court decision ref No 29 Cdo 4340/2011, 26 August 2014   

Banks may want to look for alternative ways of structuring security packages involving Czech security providers where future or contingent claims are involved following a Czech Supreme Court ruling that a Czech law governed real estate mortgage, securing future and contingent debts, will not survive a mortgagor's bankruptcy.

Czech law explicitly allows future and contingent debts to be secured by a mortgage. In a line of cases dating back to 2002, the Supreme Court has developed a doctrine (based on the accessory nature of mortgages) according to which a mortgage securing future or contingent debt comes into existence only when the relevant debt becomes existing and unconditional (although not necessarily due and payable). However, priority is determined retrospectively as of the moment of the registration of the mortgage in the Land Register. The Supreme Court's doctrine did not therefore pose a practical problem up until this recent ruling.

In this case, the bank had issued bank guarantees secured by, inter alia, a mortgage of real estate. When the borrower was subsequently declared bankrupt, the bank filed secured claims consisting of: (i) its unconditional recourse claims against the borrower arising from payments it had already made under the bank guarantees; and (ii) conditional claims in respect of bank guarantees under which it had not yet paid. All payments made by the bank under the bank guarantees were made after the opening of bankruptcy proceedings; some of them were made after the declaration of bankruptcy. The claims filed by the bank were challenged.

Supreme Court's decision

Overturning the decisions of the appellate court and the court of first instance, the Supreme Court ruled that all the claims filed by the bank were to be treated as unsecured in the bankruptcy proceedings. This was because all the filed claims came into existence (or became unconditional) after the opening of bankruptcy proceedings. The coming into existence of the mortgage was therefore prevented by Section 14 of the Bankruptcy and Composition Act,1 under which it was not possible to acquire a "right to separate satisfaction" from property belonging to the bankruptcy estate after the declaration of bankruptcy and all such rights acquired within two months prior to the opening of bankruptcy proceedings or thereafter ceased to exist if bankruptcy was declared.

Possible wider implications

The case was decided under the no longer effective Bankruptcy and Composition Act. However, it appears that the Supreme Court would have decided the same under the currently effective Insolvency Act.2 Section 109 Insolvency Act states that, after the opening of insolvency proceedings, "the right to satisfaction from security" relating to assets owned by the debtor or belonging to the insolvency estate may be "exercised and newly acquired" only in accordance with the Insolvency Act (which allows the creation of new security only for new financing approved by the creditors' committee).
The real estate mortgage was also governed by the old Civil Code3 which was replaced by a new Civil Code4 with effect from 1 January 2014. There is however no compelling reason at this moment to think that the Supreme Court would not have applied its existing doctrine to security governed by the new Civil Code. Although some commentators suggest that the approach should be different, there is little in the way of explanation for this view, and the relevant statutory rules in fact remain very similar.

Finally, whilst the case concerned a real estate mortgage, it is quite likely that the Supreme Court would have decided the same in relation to other types of in rem security, including transfers by way of security.

What next?

It is not clear to what extent the Supreme Court fully appreciated the wider impact of its decision on the practice of secured financing. The Supreme Court may (through an extended panel of at least nine judges) reverse its position on a matter of law taken in an earlier decision. However, in the meantime it makes sense for banks to try to get the Supreme Court to change its position on the issue.

Other banks no doubt participate in a number of insolvency proceedings with similar fact patterns. There should therefore be ample opportunity to present additional arguments to the Supreme Court, whether in relation to exactly the same fact pattern or in relation to insolvency proceedings governed by the Insolvency Act or security governed by the new Civil Code.

Another conceivable solution to the problem would, of course, be a legislative change.

Until then, however, banks will no doubt wish to look for alternative ways of structuring their security packages where future or contingent claims are involved.

Footnotes

1. Act No 328/1991 Coll., as amended.
2. Act No 182/2006 Coll., as amended.
3. Act No 40/1964 Coll., as amended.
4. Act No 89/2012 Coll.